**2.1 Liquidity risk**

The definition of liquidity risk can be broadly defined as the ability to meet cash at an appropriate cost. Liquidity is important for banks to carry out their business transactions, address urgent needs, satisfy customer demands for loans, and provide flexibility in achieving attractive and profitable investment opportunities. For that purpose, Islamic bank needs to implement liquidity management practices in order to mitigate the potential risk occurrence. According to Sholikhah [22], banking liquidity management is about how banks can fulfill both current liabilities and future liabilities in the event of an asset liability withdrawal or repayment. In other words, the liquidity risk appears in accordance with the agreement which has not been agreed (unexpected) previously. Therefore, bank liquidity management is required to liability management through which banks can convince the depositors concerning their fund withdrawal at any time or at maturity. Hence, looking at the potential mismatch between assets and liabilities, the banking sector needs to monitor the potential liquidity risk through its financing-to-deposit ratio or FDR variable.

country and China economy, including in Indonesia. The new normal refers to the

According to the embedded risks in the banking sector, this study employs three

FDR is a ratio that shows banking intermediaries and proxies to the liquidity of Islamic banks. The FDR is computed by dividing the total amount of financing with the total third-party funds. The FDR in Islamic bank is used to measure the capabilities of Islamic banking to meet the repayment of deposits upon maturity or without any delays. If the FDR is more than 1, it means that the total financing provided by the bank exceeds the funds collected from depositors. This situation has the potential risk to cause liquidity risk for Islamic banks. The FDR is formulated as follows:

NPF is the amount of unclaimed credit and represents the low quality of banks' assets. This variable is the ratio between the total nonperforming financing and the total financing provided by Islamic banks. The NPF is a nonperforming financing consisting of financing classified due to the lack of transparency and doubt in repayment. Usually the NPF value is the result of the failure of the debtors to fulfill their obligations. Bank Indonesia stipulated a 5% limit for Islamic banks concerning

The BOPO measures the efficiency and ability of the bank to generate profits from its business activities. A smaller BOPO represents the fact that banks can cover their expenses by using their operational revenues. The BOPO is formulated as follows:

*Total Third Party Funds collected* � 100% (1)

*Total Financing* � 100% (2)

*Total Operating Revenue* � 100% (3)

main variables that are the proxies of the three main risks, including financing, liquidity, and operational risks. The FDR, NPF, and BOPO are used to proxy the

business cycle (expansion, peak, recession, trough, and recovery phase).

**3.2 Data collecting techniques**

*Risk Analyses on Islamic Banks in Indonesia DOI: http://dx.doi.org/10.5772/intechopen.92245*

**3.3 Operational definition of observed variables**

The operational definition of these variables is as follows:

*FDR* <sup>¼</sup> *Total Financing*

the NPF value. Technically, the NPF is formulated as follows:

*NPF* <sup>¼</sup> *Non Performing Financing*

*CIR* <sup>¼</sup> *Total Operating Expenses*

Research problems will be analyzed by using vector autoregression (VAR), which is based on the risk of Islamic banks. Technically, if the data is found

observed risks.

*3.3.1 FDR*

*3.3.2 NPF*

*3.3.3 The BOPO*

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**3.4 Research estimation method**

## **2.2 Credit risk**

Credit risk is a major source of financial systems. According to the Indonesia Banks Association [23], credit risk is the risk of losses due to failure of counterparties to fulfill their obligations. Usually this risk comes from several banking functional activities such as credit or financing. Nowadays, the productive assets of banks are dominated by loans, while the most important sources of bank funds are from third-party funds or DPK so that if there is a significant increase in credit risk to banks, the influence on bank performance will be severe as the pressure from deposited funds. Hence, due to connected sources between deposited and disbursed funds, the potential loss due to financing activities must be controlled by monitoring nonperforming financing or NPF variable.

#### **2.3 Operational risk**

Operational risk affects basically the ability of banking sector to generate profits and its capacity to adjust revenues and expenses. Operational risks are triggered from banking sector activities in the midst of diversity and connectivity. Given that more diverse and competitive banking sectors exist, the banking sector tends to excessively generate assets as profit maximization motive. However, the lack of system and human capacity necessitates more investment or additional cost; otherwise, there will be less competitive and market penetration. Hence, the banking sector needs to properly monitor the ratio between its cost and revenue to ensure its sustainability and continuous profitability. The BOPO is variable to identify the potential operation risk in Islamic banking.
